The Rating Agencies and Their Credit Ratings: What They Are, How They Work, and Why They are Relevant (The Wiley Finance Series)

526 Pages·2009·2.68 MB·English

by  Herwig Langohr

The Rating Agencies
and their Credit Ratings
For other titles in the Wiley Finance series
please see www.wiley.com/finance
The Rating Agencies
and their Credit Ratings
What They Are, How They Work
and Why They Are Relevant
Herwig M. Langohr
and
Patricia T. Langohr
A John Wiley and Sons, Ltd., Publication
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LibraryofCongressCataloging-in-PublicationData
Langohr,HerwigM.
Theratingagenciesandtheircreditratings:whattheyare,howtheyworkandwhytheyarerelevant/
HerwigM.Langohr,PatriciaT.Langohr.
p.cm.–(Wileyfinanceseries)
Includesbibliographicalreferencesandindex.
ISBN978-0-470-01800-2 (cloth)
1.Creditratings.2.Creditbureaus.I.Langohr,PatriciaT.II.
Title.
HG3751.5.L3642008
332.7–dc22
2008026792
BritishLibraryCataloguinginPublicationData
AcataloguerecordforthisbookisavailablefromtheBritishLibrary
ISBN978-0-470-01800-2 (HB)
Typesetin10/12ptTimesbyLaserwordsPrivateLimited,Chennai,India
PrintedandboundinGreatBritainbyAntonyRoweLtd,Chippenham,Wiltshire
Contents
Foreword ix
Preface xiii
1 Introduction 1
1.1 Context and Premises 1
1.1.1 The Benchmarking of Default Prospects Remains Deeply Rooted
in Business Analysis 1
1.1.2 Credit Ratings Play a Unique Role in Overcoming Information
Asymmetries on the Information Exchanges 9
1.1.3 Under the Spotlight as Unique Infomediaries, the CRAs became
Strictly Regulated 13
1.2 Book Chapters 17
1.3 Supporting Materials 18
PART A CREDIT RATING FOUNDATIONS 21
2 Credit Ratings 23
2.1 The World of Corporate Defaults 24
2.1.1 What are Corporate Defaults? 27
2.1.2 The Drivers of Corporate Defaults 35
2.1.3 Recovery Rates from Defaults 39
2.2 Credit Rating Scales 40
2.2.1 Fundamental Ordinal Credit Rating Scales 43
2.2.2 Rating Scales and Observed Bond Market Credit Spreads 64
2.2.3 Market-Implied Cardinal Rating Scales and Default Probabilities 72
2.3 The Interpretation of Credit Ratings 74
2.3.1 Interpreting from the Scale 75
2.3.2 Correctly Interpreting versus Misinterpreting Ratings 78
2.3.3 Special Issues 85
2.4 Credit Ratings: Summary and Conclusions 88
3 The Raison d’Eˆtre of Credit Ratings and their Market 89
3.1 Needs for Credit Ratings – or the Demand Side of Ratings 89
vi Contents
3.1.1 Principals: Issuers/Borrowers 91
3.1.2 Principals: Fixed Income Investors 99
3.1.3 Prescribers 104
3.2 Credit Ratings as a Solution to Information Asymmetry: Economic
Analysis 111
3.2.1 Economics of Ratings: Intuition 111
3.2.2 Economics of Ratings: Analysis 113
3.2.3 The Economic Analysis of Ratings: Summary and Implications 124
3.3 Credit Rating Segments – or Scale and Scope of the Rated Universe 126
3.3.1 Industry Segments or Type of Rated Issuers 126
3.3.2 Product Segments or Types of Rated Issues 138
3.3.3 Geographical Segments or Location of the Obligor 149
3.4 Summary 158
3.5 Technical Appendix 158
4 How to Obtain and Maintain a Credit Rating 161
4.1 The Rating Preparation 161
4.1.1 The Issuer Client 163
4.1.2 The Rating Adviser-Intermediary 165
4.1.3 The Credit Rating Agency Supplier 168
4.2 The Rating 170
4.2.1 The Rating Action 170
4.2.2 Rating Follow-Up 174
4.2.3 The Rating Agreement 179
4.3 Quality of the Rating Process 187
4.3.1 Objectivity 188
4.3.2 Diligence 189
4.3.3 Transparency 191
PART B CREDIT RATING ANALYSIS 195
5 The France Telecom Credit Rating Cycle: 1995–2004 197
5.1 From Sovereign Status to Near Speculative Grade (1995–2002) 198
5.1.1 HowSovereignAaaStatusofJune1995AdjuststoCorporateAa1
in July 1996 198
5.1.2 A Company that went Public on Aa1 Status in October 1997 is
Downgraded to Aa2 in December 1999 200
5.1.3 Rapid Extension of FT’s Reach and Two Notches Downgrade to
A1 in September 2000 202
5.1.4 AWake-upCall:theOrangeIPOandSurpriseTwoNotchesDown-
grade to A3 in February 2001 211
5.1.5 The Slide Downward to Baa1 in September 2001 219
5.1.6 LoomingCrisisandTwoNotchesDowngradetoBaa3inJune2002 222
5.2 Turning Point and Rating Recovery (Fall 2002–Winter 2004) 229
5.2.1 Improvement in Outlook in September 2002 229
5.2.2 A New Start in October 2002 and Recovery Actions 238
Contents vii
5.2.3 Recovery Implementation and the Sequence of Rating Upgrades
through February 2005 244
5.3 Analysis and Evaluation 247
5.3.1 Risk Shifting at France Telecom and its Fundamental and Market-
Implied Ratings 248
5.3.2 The Restraint of the CRAs during the 2002 Crisis 253
5.3.3 The Value of Ratings to Issuers 254
6 Credit Rating Analysis 257
6.1 Fundamental Corporate Credit Ratings 257
6.1.1 Corporate Credit Risk2 257
6.1.2 Credit Risk of Corporate Debt Instruments 260
6.1.3 Putting it All Together: the Rating8 265
6.2 Corporate Ratings Implied by Market Data 274
6.2.1 The Concept 274
6.2.2 MechanicsofExtractingDefaultProbabilitiesfromMarketPrices21 276
6.2.3 Market-Implied Ratings 284
6.3 Special Sector Ratings 286
6.3.1 Sovereign Ratings 286
6.3.2 Financial Strength Ratings 291
6.3.3 Structured Finance Instruments Ratings 296
6.4 Technical Appendix 304
6.4.1 Step 1: Computing the Implied Market Value of Assets and Asset
Volatility 305
6.4.2 Step 2: Computing the Distance to Default 305
6.4.3 Step 3: Calculating the Default Probability Corresponding to the
Distance to Default 306
7 Credit Rating Performance 307
7.1 Relevance: Ratings and Value 307
7.1.1 Structural Relevance: Rating and Credit Spreads 310
7.1.2 Impact Relevance: Rating Actions and Security Price Changes 325
7.1.3 Evaluation: How Relevant are Fundamental Credit Ratings? 331
7.2 Preventing Surprise in Defaults: Rating Accuracy and Stability 332
7.2.1 Metrics of Accuracy and Stability 334
7.2.2 Analysis of the Prevention of Surprise in Defaults 353
7.2.3 Summary, Evaluation and Conclusion 356
7.3 Efficiency Enhancement: Stabilization in Times of Crisis? 356
7.3.1 The Asian Macroeconomic Financial Crisis 356
7.3.2 The Western Microeconomic Equity Crisis 363
7.3.3 The Subprime Mortgage Related Crisis 364
7.3.4 Criticisms: the Ratings in Crisis? 369
PART C THE CREDIT RATING BUSINESS 371
8 The Credit Rating Industry 375
8.1 The Rise of the Credit Rating Agencies 375
viii Contents
8.1.1 Origins 375
8.1.2 Macroeconomic Forces Shaping the Current Industry 378
8.1.3 The Current Structure of the Industry 384
8.2 Industry Specifics and How They Affect Competition 407
8.2.1 Agencies Compete for the Market rather than in the Market 407
8.2.2 The Business Model and Profit Drivers 411
8.2.3 Some Dynamic Aspects of Competition among CRAs: A Small
Number of Players can be Consistent with Intense Rivalry 418
8.3 Industry Performance 419
8.3.1 Performance for CRA Shareholders 419
8.3.2 Performance of Ratings as a Public Good 420
8.3.3 Performance for Issuers 427
8.3.4 Performance for Investors 427
8.4 Conclusion 428
9 Regulatory Oversight of the Credit Rating Industry 429
9.1 The Regulatory Uses of Ratings 430
9.1.1 Prudence 435
9.1.2 Market Access 436
9.1.3 Investor Protection 439
9.2 The Regulation of the Industry 440
9.2.1 The Regulatory Options 440
9.2.2 Worldwide Regulatory Initiative: the 2004 IOSCO Code of
Conduct 443
9.2.3 The 2005 European Union Policy on Credit Rating Agencies 444
9.2.4 The US ‘Credit Rating Agency Reform Act of 2006’ 448
9.3 Analysis and Evaluation 455
9.3.1 The EU and the US Approaches Compared 455
9.3.2 The Positions of the Main Stakeholders 461
9.3.3 Comments and Evaluation on Regulatory Options 466
10 Summary and Conclusions 469
10.1 The Challenges Facing Rating Agencies Today 469
10.1.1 From Regulatory Legitimacy to Market Legitimacy 469
10.1.2 Financial Innovation 472
10.1.3 Growth and Globalization 473
10.2 Conclusion 473
References 475
Index 495